**2.4 Basel III**

Global economy suffers severe financial distress during 2007–2008. Excess liquidity in the banking sector resulting in too much weak credit or loans to subprime borrowers is at the top of the list behind the crisis of 2007–2008. Other reasons that triggered the global crisis are excessive risk taken by the financial firms, excess leverage, lack of adequate quality capital, inadequate liquidity buffer, and excess dependence on the credit rating agency [6]. The crisis revealed the lapses in the regulatory framework, market transparency, and supervision quality [7]. The crisis of 2007–2008 exposed the shortcomings of Basel II in managing the systematic risk and revealed the moral hazard problem linked with the systematically important banks.

In response to the crisis, BCBS addressing the weaknesses proposed revised capital framework that enforces raising higher quality of capital. It suggests building more common equity to improve loss absorption capacity and maintaining two liquidity standards and leverage ratio. The purpose of the regulation is to increase the level and quality of capital, enhance risk capture, constrain bank leverage, improve bank liquidity, and limit pro-cyclicality. In 2017, the committee reforms Basel III 2010 that seeks the credibility in risk calculation and improvement in comparison on the capital position of the bank [8].

The minimum amount of common equity to be maintained is increased from 2 to 4.5% and capital conservation buffer of 2.5% of the risk-weighted assets of the bank. In addition, the regulatory authority can enforce additional capital buffer during the period of excess credit growth. For systemically important banks, additional loss absorbency capacity can be introduced [7]. In 2017 reform, the committee has brought some changes in calculating credit risk through detailed risk weighing rather than flat risk weight for loans against residential and commercial real estate. In addition, banks are advised to perform due diligence in case of relying on external credit ratings.

To make the banking industry more stable, building capital alone is not sufficient. Therefore, to protect against buildup of excessive balance sheet leverage, Basel III introduced non-risk-based leverage ratio. This non-risk-based leverage ratio is Tier 1 capital to average total restated balance sheet assets over the quarter. The leverage ratio should be minimum 3%.

Moreover, for better resilience, (a) liquidity coverage ratio (LCR) for shortterm disruption and (b) net stable funding ratio (NSFR) for long-term liquidity mismatch in the balance sheet are introduced. LCR is a standard for a minimum level of liquidity where the institution can generate enough cash outflow from the high-quality liquid assets in any short-term distress situation. The LCR standard is measured by the ratio of stock of high liquid assets to total net cash outflows over the next 30 calendar days. However, NSFR measures the sustainable funding ratio relating to the assets and off-balance sheet activities [9]. NSFR is the ratio of the available amount of stable funding to the required amount of stable funding, which should be greater than 100%. It suggests the banks to rely on long-term liabilities over short-term liabilities and small and retail liabilities over wholesome liabilities in case of short-term maturity (less than 1 year) for better resilience.

**11**

*Capital Adequacy Regulation*

*Minimum capital requirement ratio.*

**Table 2.**

*DOI: http://dx.doi.org/10.5772/intechopen.92178*

The crisis also revealed that the existing regulation has not appropriately covered

major on- and off-balance sheet items, trading book, and derivative-related risk exposure. BCBS advises a revised framework to address the trading book exposure under Basel III that increases the capital charges around three to four times of previous level. Basel III upholds the counterparty credit risk management and collateral risk management and addresses the pro-cyclicality effect and credit valuation adjustment risk to reduce the reliance on external credit rating agencies. **Table 2** presents the present capital ratio and liquidity ratio advised by the committee [10].

**Particulars Minimum % of RWA**

Common equity 4.5 Capital conservation buffer 2.5 Tier 1 capital 6 Total capital 8 Liquidity coverage ratio ≥100 Net stable funding ratio ≥100

The case of Lehman Brothers and AIG call attention to how a single firm can boost up shock in the financial market as well as in the global economy. The financial crisis of 2007–2008 has revealed that microprudential guideline alone is not sufficient to address the systematic risk. Macroprudential regulation that takes into account the risk arising from interconnectedness of the financial institutions is important to respond to the systematic risk and financial stability in the economy. Therefore, the macroprudential guidelines impose additional capital require-

ment for systematically important banks to reduce their default probability. BCBS advises building common equity of 2.5% of risk-weighted asset as capital conservation buffer so that in times of distress, this buffer can be scaled down to absorb losses. BCBS also advises the regulatory authorities to raise an additional countercyclical capital buffer of 2.5% to respond with excessive credit growth that may induce systematic risk in the financial sector. Banks incur a huge loss during downturn followed by a long excessive aggregate credit growth. After the asset price bubbles loans go unpaid, prices go down, banks loan decrease, and level of defaults even increases more [11]. To prevent this systematic risk, banks are advised to build additional capital up to 2.5% during the credit growth time that ensures the sufficient level of capital during the distress periods. It ensures that during the downturn, the banking institution has enough cushions to absorb the additional loss and provisioning. It also intends to support the financial stability by building countercyclical capital buffer during boom period through increasing to the cost of

BCBS provides capital standard for conventional banks but Islamic banks are also under the same jurisdiction toward a safe and sound banking system. Islamic banks differ from the conventional banks in their operation due to

*2.4.1 Capital conservation buffer and countercyclical buffer*

credit which reduces the demand for it [12].

**3. Islamic banking and capital regulation**


#### **Table 2.**

*Banking and Finance*

accounting requirements.

cally important banks.

comparison on the capital position of the bank [8].

case of relying on external credit ratings.

The leverage ratio should be minimum 3%.

**2.4 Basel III**

Bank supervisors having their power to disclose requirements to the operating banks contribute to safe and sound banking practices. Banks will have a formal disclosure policy approved by the board of directors, which exhibits the items to be disclosed, frequency, and internal control over the process. These capital and risk disclosure requirements do not conflict with and minimize the scope of the

Global economy suffers severe financial distress during 2007–2008. Excess liquidity in the banking sector resulting in too much weak credit or loans to subprime borrowers is at the top of the list behind the crisis of 2007–2008. Other reasons that triggered the global crisis are excessive risk taken by the financial firms, excess leverage, lack of adequate quality capital, inadequate liquidity buffer, and excess dependence on the credit rating agency [6]. The crisis revealed the lapses in the regulatory framework, market transparency, and supervision quality [7]. The crisis of 2007–2008 exposed the shortcomings of Basel II in managing the systematic risk and revealed the moral hazard problem linked with the systemati-

In response to the crisis, BCBS addressing the weaknesses proposed revised capital framework that enforces raising higher quality of capital. It suggests building more common equity to improve loss absorption capacity and maintaining two liquidity standards and leverage ratio. The purpose of the regulation is to increase the level and quality of capital, enhance risk capture, constrain bank leverage, improve bank liquidity, and limit pro-cyclicality. In 2017, the committee reforms Basel III 2010 that seeks the credibility in risk calculation and improvement in

The minimum amount of common equity to be maintained is increased from 2 to 4.5% and capital conservation buffer of 2.5% of the risk-weighted assets of the bank. In addition, the regulatory authority can enforce additional capital buffer during the period of excess credit growth. For systemically important banks, additional loss absorbency capacity can be introduced [7]. In 2017 reform, the committee has brought some changes in calculating credit risk through detailed risk weighing rather than flat risk weight for loans against residential and commercial real estate. In addition, banks are advised to perform due diligence in

To make the banking industry more stable, building capital alone is not sufficient. Therefore, to protect against buildup of excessive balance sheet leverage, Basel III introduced non-risk-based leverage ratio. This non-risk-based leverage ratio is Tier 1 capital to average total restated balance sheet assets over the quarter.

Moreover, for better resilience, (a) liquidity coverage ratio (LCR) for shortterm disruption and (b) net stable funding ratio (NSFR) for long-term liquidity mismatch in the balance sheet are introduced. LCR is a standard for a minimum level of liquidity where the institution can generate enough cash outflow from the high-quality liquid assets in any short-term distress situation. The LCR standard is measured by the ratio of stock of high liquid assets to total net cash outflows over the next 30 calendar days. However, NSFR measures the sustainable funding ratio relating to the assets and off-balance sheet activities [9]. NSFR is the ratio of the available amount of stable funding to the required amount of stable funding, which should be greater than 100%. It suggests the banks to rely on long-term liabilities over short-term liabilities and small and retail liabilities over wholesome liabilities

in case of short-term maturity (less than 1 year) for better resilience.

**10**

*Minimum capital requirement ratio.*

The crisis also revealed that the existing regulation has not appropriately covered major on- and off-balance sheet items, trading book, and derivative-related risk exposure. BCBS advises a revised framework to address the trading book exposure under Basel III that increases the capital charges around three to four times of previous level. Basel III upholds the counterparty credit risk management and collateral risk management and addresses the pro-cyclicality effect and credit valuation adjustment risk to reduce the reliance on external credit rating agencies. **Table 2** presents the present capital ratio and liquidity ratio advised by the committee [10].
